Junk bonds are debt securities rated below investment grade by rating agencies like Moody's or Standard & Poor's. This lower rating reflects a higher risk of default by the issuer. In exchange for that risk, junk bonds pay higher interest rates (yields) than investment-grade bonds to attract investors.
When a company issues bonds, rating agencies assess its ability to repay. If the company has weak finances, declining revenue, high debt, or other concerning fundamentals, the bond receives a speculative-grade (junk) rating. Investors demand higher yields as compensation for the increased default risk.
For traders, junk bonds have distinct characteristics. Their prices move more sharply in response to changes in the issuer's financial health or broader credit market stress than investment-grade bonds do. This volatility creates both risk and opportunity—a junk bond's value can fall quickly if the issuer deteriorates, but can also rise sharply if the company stabilizes. Unlike stocks, you receive interest payments along the way, though only if the company doesn't default.
Key practical considerations: liquidity can be thinner than investment-grade bonds, meaning wider bid-ask spreads and difficulty selling quickly. Default rates spike during recessions and credit crunches. Portfolio diversification with junk bonds means accepting higher volatility in exchange for higher yields, and sizing positions carefully to match your risk tolerance.
